March Agency MBS Update

Monthly Commentary

The slow and steady widening of agency MBS spreads that has characterized 2018
thus far continued throughout March. Interest rates ticked up sharply in the first
six weeks of the year, causing the duration of the Bloomberg Barclays MBS Index
to extend. Relative and absolute valuations struggled across January and February
as a result. The impetus for further weakness in agency MBS was different as the
calendar flipped to March. After having reached their highest levels since 2014, 30
year mortgage rates halted their increase as yields on 10 year U.S. Treasuries fell
across the month. While seemingly a positive development for the agency MBS basis,
pressure on risk assets and volatility simmering just beneath the surface kept agency
MBS valuations in check yet again. A slightly more hawkish than expected FOMC
meeting, in which the Fed hiked interest rates as expected, did nothing to stem the
tide. The continued unwinding of historically supportive monetary policy continues
to be a negative for agency MBS, with the mortgage pools on the balance sheet set
to slowly run off over the next few years. The tepidly negative reaction by mortgages
to a relatively benign interest rate picture suggests that the lack of significant interest
rate volatility might not be enough to hold in relative agency MBS valuations in
the current market environment. In aggregate, the Bloomberg Barclays MBS Index
posted excess returns of negative 14 basis points (bps) in April, sending year-todate
excess performance to negative 39 bps, with year-to-date absolute total returns
recovering slightly to end the quarter at negative 1.19% overall.

Performance within the agency MBS coupon stack was largely what one would expect
from a quiet month punctuated by a flatter yield curve and lower U.S. Treasury yields.
In Fannie Mae 30 year (FNCL) collateral, lower coupons slightly outperformed their
higher coupon counterparts. FNCL 3 posted excess returns of -9 bps relative to
benchmark U.S. Treasuries, while FNCL 4s and 4.5s came in at -22 bps and -29 bps,
respectively. Lower coupons rode the back of a flatter yield curve and a rally in longterm
rates, enabling higher coupons to outperform on a relative basis for the first
time in 2018. The fact that lower coupons still underperformed U.S. Treasuries on a
relative basis despite conditions that were conducive to success suggests investors
remain wary of longer duration MBS assets and potential extension risk. Ginnie Mae performance was largely in line with FNCL collateral in March,
as the sharp swings in performance between conventional
and Ginnie Mae MBS that have characterized much of the last
six months did not materialize. Ginnie Mae 30 year (G2SF)
3.5s underperformed by 12 bps while 4s came in at -34 bps on
the month. Headlines were minimal in higher coupon G2SF,
but the market continues to search for further regulatory relief
from the scourge of extremely fast speeds due to aggressive
refinance activity. Finally, TBA rolls struggled as March wore
on, as a sharp uptick in short-term credit rates such as the
London Interbank Offered Rate (LIBOR) dragged on TBA
valuations across the coupon stack. While the exact cause
of the short-term financing rate increase are numerous and
not simply related to the Fed hike, fluctuations in LIBOR give
investors another reason to be wary of TBA rolls.

With the regulatory outlook surprisingly quiet, the most
notable market development was a sharp unforeseen
widening of LIBOR/OIS (Overnight Indexed Swap) spreads.
Since the start of the year, the 3 month LIBOR/OIS swap has
widened from 25 bps out to 58 bps. LIBOR/OIS is a spread
that attempts to measure the difference between private
short-term interest rates and short-dated risk-free borrowing
rates. Historically, when the spread widens sharply, it is a
sign that money is tight and there is potentially a lack of
systemwide liquidity. The 58 bps month end spread is the
largest since the middle of the global financial crisis. While
investment grade credit spreads have widened and stocks
have struggled over the past three months, there is no clear
sign of systemwide contagion. One of the primary causes of
the move is tax reform. Part of the 2017 tax law change was
the implementation of the Base Erosion and Anti-Abuse Tax
(BEAT). BEAT creates a 10% minimum tax for some large
corporations with more than $500mm in income. The tax has
forced some large banks to use unsecured funding for cash
rather than currency swaps, increasing the supply of short
term commercial paper. Furthermore, repatriation from the
new tax bill has caused corporate treasurers to change their
buying patterns, further eroding the supply demand picture in
short-term corporate markets. The higher funding rates have
repercussions for agency MBS. Specifically, higher funding
costs should weigh down TBA roll levels, and hinder agency
MBS basis performance. While different investors fund at
differing levels, it is hard to concoct a scenario where sharply
higher LIBOR OIS spreads are positive overall for agency MBS
valuations going forward.

The first quarter saw a sharp uptick in interest rates, followed
by a plateauing in the month of March. This was in sharp
contrast to the latter part of 2017, a period where interest
rates were largely stagnant, volatility was low, and the yield
curve was consistently flatter. Agency MBS valuations have
been challenged since the winds shifted, struggling in
both steepening and flattening curves, and across various
interest rate levels. Meanwhile, while volatility is no longer
dormant, it has yet to return to anything close to long run
historical norms. The continuing drag on valuations from
higher funding rates, an increasingly hawkish Federal Reserve,
and increased volatility could severely hinder performance
over the next three quarters. The flip side is that an already
extended index leaves little room for extension risk, and
elevated rate levels mean that prepayments should remain
subdued even if interest rates rally sharply. Additionally, any
weakness in risk assets is likely to weigh more heavily on
other sectors of the fixed income universe. Thus, despite the
ever present possibility of continued headwinds, agency MBS
valuations may not be as concerning as many investors fear
as the calendar turns to the second quarter of 2018.